Canada: The Kitco Metals Inc. Decision: How To Restrict The Tax Authorities' Recourse To Set-Off In The Context Of A Restructuring

On February 1, 2016, the Superior Court of Québec
delivered its judgment in the important Kitco Metals Inc.
case 1. In her ruling, Madam Justice Marie-Anne
Paquette refused to allow federal and Québec tax authorities
(the "Agencies") to set off a tax debt that predated the
commencement of the restructuring proceedings against GST and QST
input tax credits/refunds that had been "earned"
subsequent to the filing of insolvency proceedings, during a period
in which the taxpayer enjoyed the protection of the
Companies' Creditors Arrangement Act
("CCAA"). This decision is highly significant inasmuch as
it considerably restricts the scope of the set-off or compensation
mechanism that tax authorities routinely use in the context of
insolvency. It should be noted, however, that the ruling is
currently under appeal.

Background

Kitco Metals Inc. ("Kitco") is in the business of
purchasing scrap gold from various suppliers in order to extract
and then sell pure gold from it. Although the sale of scrap gold is
taxable for GST and QST purposes, the sale of pure gold by the
refiner (or by the person on whose behalf gold is refined) is
zero-rated. Kitco can therefore claim GST and QST input tax
credits/refunds ("ITCs/ITRs") to recover the taxes it
pays to its suppliers, including those that supply it with scrap
gold.

In 2010 and 2011, the Agencies issued notices of assessment to
Kitco in order to reclaim ITCs/ITRs for GST and QST that the
company had allegedly never actually paid to its suppliers (the
"Notices of Assessment"). The Agencies contended that
Kitco had taken part in a fraudulent tax scheme involving several
of its suppliers. Strongly objecting to the Notices of Assessment,
Kitco challenged them before the Tax Court of Canada and the Court
of Québec. The disputed tax debt is approximately $313
million (the "Disputed Tax Debt").

In June of 2011, as a result of the enforcement measures
implemented by the Agencies to collect the $313 million, Kitco
filed a notice of intention to make a proposal under the
Bankruptcy and Insolvency Act ("BIA") and a
notice of stay of proceedings. One month later, it was agreed to
continue the insolvency proceedings under the CCAA instead.

In the meantime, during its restructuring, Kitco continued to
operate and to claim ITCs/ITRs on a monthly basis. Those claims
related to subsequent transactions with suppliers that are
unrelated to the Disputed Tax Debt. While the Agencies do not
challenge the validity of these ITCs/ITRs (the "Uncontested
ITCs/ITRs") they have refused to pay the claims made since the
commencement of the insolvency proceedings, preferring instead to
set them off against the Disputed Tax Debt. The amount set off in
this manner, and therefore not paid out to Kitco, totals
approximately 1.8 million and is increasing every month.

Kitco, the monitor, as well as an important creditor that we are
representing, challenged the validity of this
set-off/compensation.

Analysis

In its decision, the Court concluded that the Agencies could not
set off the Uncontested ITCs/ITRs against the Disputed Tax Debt.
Analyzing section 21 of the CCAA, which allows for set-off in the
context of an insolvency on claims made against the debtor company,
the Court held that set-off (or compensation) is only permitted
where the claims stem from obligations incurred before the earlier
of the commencement date of proceedings under the CCAA and the date
of bankruptcy. This automatically excludes the Uncontested
ITCs/ITRs, given that they relate to transactions Kitco entered
into after the commencement of its restructuring proceedings under
the CCAA.

The Court also noted that because the application of the set-off
mechanism in the context of insolvency derogates from the
underlying principle of equality among creditors, it must be
interpreted narrowly. In D.I.M.S.2, the Supreme
Court of Canada stated that there exists an implicit rule under the
BIA whereby the set-off mechanism only applies to mutual debts
incurred before bankruptcy. Seeing no reason to differentiate
between the context of a bankruptcy and that of an arrangement, the
Court ruled that this interpretation also applied under the CCAA.
The Uncontested ITCs/ITRs and the Disputed Tax Debt are not mutual
and are completely unrelated, except for the identity of the
parties, and they relate to contexts, periods and transactions that
are separate and independent. There cannot, therefore, be any
set-off or compensation.

Finally, in obiter dictum, the Court rejected the
presumptions created under tax laws and relied upon by the
Agencies, according to which claims formulated in the Notices of
Assessment would be deemed valid and exigible notwithstanding
objections of the type Kitco had raised in this case. These
presumptions go against the principle of equality among creditors
and the Crown's status as an unsecured creditor under the CCAA
and the BIA, and are not the subject of an explicit exception under
these statutes. Without the benefit of these presumptions, the
Disputed Tax Debt cannot meet the criteria of the certain, liquid
and exigible test necessary to effect set-off, or compensation,
under Quebec civil law.

The Court consequently ordered the Agencies to reimburse the
Uncontested ITCs/ITRs totaling approximately $1.8 million.

Conclusion

Subject to a possible contrary ruling by the Québec Court
of Appeal, one can expect that recourse to set-off will become
increasingly difficult for tax authorities when a taxpayer is
placed under the protection of the CCAA or BIA regimes. The
mechanism will only apply to mutual debts incurred before the date
of insolvency. Furthermore, the presumptions and priorities created
under tax laws will no longer be applicable in the context of
insolvency without an explicit exception in the CCAA or the
BIA.

The authors wish to thank Sara Shearmur for her invaluable
help in writing this article.

Canada's wealthiest individuals have been put under a microscope.The CRA has launched a project dubbed the "Postal Code Project" that is targeting taxpayers residing in affluent neighbourhoods across Canada.

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